Economics/Indirect Taxes and Money Supply

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Expert: Michael Taillard - 6/26/2013

QuestionDr. Michael Taillard,

I´m wondering about the relation between money supply and indirect taxes (i´m refering do VAT like taxes).

If government decides to increase VAT, what should happen do money supply? I reason that since Price Levels are higher, a higher money supply should be required. However, I can also reason that, if government spending increases along with VAT, maybe no money supply increases should be required.

AnswerFiscal policy (taxing and expenditures) generally aren't used to manage money supply. Since governments only collect taxes periodically, and they spend that tax money over the course of a year, really, they're not changing the supply of money. Theoretically, the money supply could be managed, if the government maintained a budget surplus that they just stuffed away in their coffers never to see the light of day again, but that rarely, if ever, happens.

So, what happens with changes in taxes then. The money that we pay in taxes is generally kept by the businesses or people to whom we pay taxes, until it's tax time. So people are free to reinvest or spend that tax money they've collected until it's time to pay taxes. After tax season, then the government has decreased the amount of money in circulation, but then spends that money over the course of a fiscal year, generally spending more than it actually collected, by issuing debt. That debt doesn't increase money supply, it increases something called monetary velocity. Monetary velocity is the speed with which money circulates through the economy. As prices increases as a ratio of total money supply, the size of the transactions in each exchange also increases, and so larger volumes of money are moving more frequently through national transactions.

There are a few types of taxes that go directly to government entities as we use them. Postage, for example, is a type of tax. Tariffs, including import VAT taxes, are also sometimes paid up-front, but the result is the same.